‘Are we prepared to lose 30 per cent of GDP to save 3 per cent because of a financial shock?’
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Percy Mistry: While people refer to the report as the Percy Mistry report, I refer to it as the MIFC (Mumbai International Financial Centre) report. Most of the credit for the report should go to Ajay Shah and K.P. Krishna, the stalwarts responsible, more than I, for its eventual production. Much has been said about the chairman not signing the report—but it wasn't to dissociate myself with the report. After the report had been written, I have been a great advocate of it, pushing what it has to say and defending what it has to say. The personalisation, however, makes me uncomfortable. Still, I think the report, along with Raghuram Rajan's report (on financial sector reform), actually does provide a good framework for where India can now go with financial sector reforms. I don't think there is anything left out of these two reports where anyone should ask: 'Well, what do we do?' What should be done is extremely clear from both these reports. The issue is one of consensus around getting it done.
Subhomoy Bhattacharjee: Why did it take us so long to get down to the ideas in your report? Was it simply inertia?
I think inertia has something to do with it. I am often fond of saying and I am not liked for saying that over the last 60-odd years, we seem to have developed a sort of national strategy where our approach to everything is meddle and muddle but stay in the middle. It's never a strategy with a very clear sense of goals and destinations or of a path which is laid out in a straightforward way. And this is always explained by "political compulsions". What can be done in a straight forward way is not gonna be done in a straight forward way. In the private sector, things have changed dramatically in the last 15 years. I think those changes will occur in the public sector as time goes by. Is this a report which should have been done much earlier? I am not sure about that. When you look at the reasons why the report came about, it was because a lot of people at a particular point in Mumbai were pushing for something they thought was important but most of them viewed it as a real estate proposition. People think that 20 gleaming buildings make you an international financial centre. In a country like India, this proposition is absurd.
So, we turned the question on its head. If Mumbai needs to be an international financial centre, what kind of financial system should it (and India) have in the first place? And, did we have the kind of financial system that would enable any city in India—Mumbai because it is India's national financial centre—to become a credible international financial centre? That was our starting point.
That's what led to the report unfolding the way it did. We thought we could create the kind of financial system that would make Mumbai a very vibrant and capable international financial centre and where India-related businesses was concerned, the kind of financial centre that could take a lot of business away from Singapore, London and at the same time generate a whole load of business that has not yet emerged. So, I just don't think the timing would have been right a long time ago.
Dhiraj Nayyar: Do you agree with the view that real sector reforms should precede financial sector reforms?
I don't buy into this real sector versus financial sector dichotomy the way most traditional economists do. In the US, we call it the sort of Main Street versus the Wall Street syndrome. I think the two are inextricably wedded and what happens in the real sector at any point of time reflects how efficient, inefficient, good or bad your financial system is and that it is really impossible to separate the two. The additional thought we have put into the report is where international finance is concerned you are actually talking about real sector activity in terms of provision, like the IT sector, where the provision of goods over services actually enhances the value added in the economy through a whole new range of activities which traditionally you would call real sector.
Saubhik Chakrabarti: What is your view on moral hazard in the context of a series of bailouts in the US?
The whole issue about privatisation of profit and socialisation of cost—people often say the taxpayers have picked up the bill—is a very loose term. When the whole thing is unfolded you often find that more often than not, the taxpayers have actually made a profit. If you remember there was a huge argument about the Hong Kong monetary authority intervening in the stock market. As a result of the intervention, which theoretically put the taxpayer at risk, they are sitting on a profit of $10.5 billion.
Sometimes providing liquidity does not involve a fiscal cost. This continuous confusion that because the authorities are involved somewhere the taxpayers are paying the bill is just a fundamentally misleading argument.
Consider the consequences if Fannie & Freddie had failed. What if the entire guarantee mechanism of a $6 trillion mortgage market had suddenly got zero credibility and credit rating behind it? What kind of bill would the taxpayer have had to pay then? It's the looseness of thinking which does not consider the counter factual that leads you to assume this lovely phrase—that these guys privatise profit when the going is good and now that the whole thing collapsed the cost is being socialised. Frankly, if you hadn't done the rescue, the cost would have been socialised at a much higher level in a much more dangerous way.
Saubhik Chakrabarti: How would you approach the question of managers' risk taking?
It's a question that has no definitive answer. It's a question that bothers me. But take the situation in Bear Stearns where the chief executive saw his net worth in terms of his options and shares in Bear Stearns come down from $1.6 billion to $60 million. Now to say that he didn't take a haircut would be unfair. Nobody, however, has pity for anyone who has $60 million still left with him. In people's minds if you have more than a million you are in a funny money territory. If you look at most of these institutions, shareholders have lost billions.
Some people argue it's a disproportionate hit given the fact that the problem had actually originated with the regulator. There was a moral hazard of regulation. The Federal Reserve obviously in retrospect, everyone agrees, printed far too much money and the regulators did not regulate the market which is the easiest market in the world to regulate, the US mortgage market. Also, I have reservations about Alan Greenspan's role (as the Chairman of the Federal Reserve). I think he was absolutely wrong to believe that central bankers should not interfere with asset bubbles, that they should instead deal with the consequences of asset bubbles bursting. Frankly, I think we have been through three cycles of that and by now we should say that the cost is too high.
Of course, the issue of incentives in financial firms—whether the kinds of bonus systems we have provide perverse incentive for risk taking—is a very legitimate question. Whether these bonuses should be taxed, whether these should be exercisable in the short term, if exercised in the short term should they be taxed at ridiculous rate, whether they should accrue upon the retirement of the people—all these issues are legitimate questions. But there are questions of theory which impinge upon practise. At the end of the day if you de-motivate a good manager and you turn a very good bank executive into a hedge fund manager, I don't know whether you have actually added to the net contribution of human welfare. The reason I am answering in this bizarre sort of way is that I honestly have been grappling with this issue for the last 17 years and there is no definitive answer. Any professor of finance who comes up with one doesn't know what he is talking about.
One of the great dangers of monetary policy today is that there is no coordinated emission of global liquidity. You have got three global reserve currencies—the yen, euro and the dollar. I think in 10-15 years, we have to prepare for the fact that the Indian rupee and the Chinese yuan will be two more global reserve currencies. Given the way the world is structured today, unless those monetary authorities coordinate the emission of global liquidity we are going to have problems in the system somewhere.
Dhiraj Nayyar: Some would argue that China and India have grown spectacularly with capital controls, whereas other countries with very liberal capital account regimes have been prone to crisis and slower growth. Your views?
Its like looking at the bushman of Kalahari and then asking whether being 4'7" makes a better marksman. It's a correlation of totally, in my view, wrong variables. One can say that India and China have grown and they have capital controls. China has got reserves of $1.5 trillion, India has got reserves of $300 billion though it's going down. But these are signs of weakness. To me they are not signs of strength. You can understand reserves building up on the part of Singapore or Saudi Arabia if you are making a billion dollars a day from oil. But in continental economies like India and China, the growth of reserves of this type is essentially indicative of two fundamental problems—one is the financial system is a primitive relative to the needs of the real economy and two, the financial flows which should be managed through a market system are largely managed by the government
In my view if you know that 10 years from now you are going to be one of the four largest economic blocks of the world, it makes absolutely no sense in logic or morality to carry on the way we are doing today. We have to liberalise our financial system, we have to employ global standards, we have to create global institutional players and we have to integrate with that system.
Dhiraj Nayyar: You advocate financial liberalisation. But isn't it true that people worry about financial liberalisation because the institutional mechanisms are often not good enough which is why countries like India and China opt for the conservative approach?
It worries me much more that 300 billion of national assets are managed by maybe 14 guys who may not at all times know what they are doing.
Dhiraj Nayyar: You think that's more worrying than the collapse of couple of banks?
This is one area where I would be on the side of the devils rather than the angels. We have permitted institutions to grow to sizes where they are now too large to be allowed to fail without systemic risk. There is no question in my mind that in an overall cost benefit sense the cost of financial repression to India is far greater than the potential cost of some of the risks of financial liberalisation materialising. The more you liberalise a financial system, the more you run the risk that some failures will materialise. But as we said in our report, what is worse? That we repress our economy from growing at 3 per cent a year faster than it could or should in order to save once every ten years a financial shock which may cost us 3 per cent of GDP? So we are prepared to lose 30 per cent of GDP to save 3 per cent of GDP because of a financial shock. That is not the brand of arithmetic I would subscribe to. I will be perfectly willing to run the risk every ten years of a financial shock that cost me 3 per cent of GDP if in the previous nine years I accrue 27 per cent of GDP.
Sunny Verma: With the change of guard at the helm of RBI do you expect any momentum on the reforms mentioned in the MIFC report? And what about political constraints?
The honest answer is I don't know. I have every hope that the new Governor will bring about a new ethos. The one thing I would like the new Governor to do is not to carry on business as usual. He has to really engage the RBI bureaucracy in a fundamental re-thinking of what the role of the RBI should be in the Indian financial system of the future. The Indian financial system that we have at present has simply not caught up with the progress that our real economy has made since 1993. It is not at all well formulated to serve the needs of the real economy. The political constraints are more imagined than real. Everybody talks of political constraints so much that they actually constrain themselves because of the volume of talks about political constraints.
Sunny Verma: What are the three reform initiatives that you would like to see done?
I think we need to set a deadline of 2010 to have a completely open capital account as the first priority. From this a whole lot of things follow. The second thing I would do would be to move as rapidly as possible to introduce options in the currency market futures and options on interest rates, introducing a credit default swap market as soon as possible. The third thing I would do is to have massive structural reforms in the bond markets.